The SeniorCare Investor: Average Bed And Unit Prices Soar, Beating Expectations
We knew that when we released the results for the 2003 acquisition market a year ago, the 17% plunge in the average price per bed for skilled nursing facilities did not completely reflect where "values" were heading. What it did reflect was the relatively low quality of what was actually in the market and sold. Perhaps it is only fitting that a year after the average price per bed plunged to a 10-year low it should soar to a 10-year high.
As can be seen below, in 2004 the average price per bed paid in the skilled nursing facility market jumped by just over 40% to $44,600 per bed, while the median increased by 34% to nearly $36,000 per bed. The spread between the average and the median was the highest ever recorded. What this tells us is that average is being overly influenced by transactions at the high end of the market. Obviously, these are not reasonable percentage increases in any market and are unusually large because of the equally unusually low prices paid in 2003. But even after removing the extremes on both ends, the average is still just above $40,000 per bed. After a slow start in the first half of 2004, much of the higher-end buying took place in the last two quarters of the year.
Ignoring 2003 for now, the prices in 2004 reflect a more reasonable 16% and 1% increase in the average and median price per bed, respectively, when compared with 2002. And 2002 was fairly similar to both 2001 and 2000, a relatively stable three-year period for average prices paid while the industry was going through its period of financial distress and bankruptcies.
There are many reasons for this unusual spike in the average price per bed, but it is unclear for how long they will impact the market. The most noticeable explanation has to do with the quality of nursing facilities sold last year. Even though there were still many divestitures from some of the large chains and other castaways, high quality, newer and very profitable nursing facilities, especially in expensive real estate markets, finally came on the market.
In today’s market, operators were willing to pay up for that hard-to-find quality in a sector where 30-year old facilities with a 70% to 80% Medicaid census tend to be the norm. Paying up meant a high price per bed, which has always been a questionable valuation metric, as opposed to cap rates coming down to silly levels.
Not all of the sales in 2004 involved higher quality facilities, but the Medicare rate increases that went into effect during the past 18 months impacted all nursing facilities participating into the Medicare program, regardless of quality. Since most operators do not expect to make much money on Medicaid (depending on the state), Medicare has been the cash flow haven as private pay patients slowly diminish in number.
The Centers for Medicare and Medicaid (CMS) has been lenient, admitting that the Medicare reimbursement for nursing facilities compensates for the miserly Medicaid rates. This attitude may change, especially in 2006 if Congress and CMS decide to listen to the MedPAC recommendations to not allow an increase and perhaps to scale back the rates.
In the meantime, the Medicare-related profits put some bounce back into the cash flow of many providers, allowing the prices paid to rise, even though the multiples did not necessarily change. Our suspicion a year ago that some potential sellers were waiting to show the financial impact of the new Medicare rates before selling their facilities appears to have been borne out.
But the large chains, although dwindling in number, have still been net sellers and have yet to take part in the new buying interest. Perhaps they are simply savoring a period of some decent cash flow and don’t want to mess up a good thing with a reckless acquisition or two. Most of the buying is still being pursued by the smaller, regional companies as well as many "mom and pops" that, capitalizing on the local nature of the business, are finding attractive turnaround situations. Unfortunately, the current reliance on Medicare for a disproportionate share of profitability puts these buyers at the mercy of legislative changes and budget cuts. But then again, what else is new?
After an 11% increase in average per-unit prices in 2003, the assisted living market took off in 2004, with the average price paid increasing by another 31% to just over $95,000 per unit. The median had a more modest 18% jump in 2004 to $75,000 per unit. The spread between the average and median, at $20,000 per unit, was the second widest ever, with only 2000 posting a slightly wider spread. Once again, some transactions at the high end are driving that spread.
These increases should not come as a surprise to anyone in the market because, even though there continue to be remnants of the distressed assisted living sell-off of the past several years, high-end facilities finally made their long-awaited appearance. And like the skilled nursing market, most of the activity involving the more expensive assisted living facilities (above $100,000 per unit) occurred in the second half of the year and has continued into 2005.
There were several factors that converged during the year to cause a new high in assisted living prices. For years, there had been very few high-end, but stabilized, facilities available for sale. Those that fit this description were usually sold to an investor who retained the seller under a long-term management contract. We consider these transactions to be non-arm’s length and are not included in our annual statistics because in addition to the condition of the seller keeping the management contract, the seller also often keeps an equity interest in the property. But during 2004, as single digit cap rates became acceptable for quality assisted living properties, potential sellers began sticking a toe in the acquisition market and hungry buyers pulled them all the way in.
More than anything else, the decline in cap rates for assisted living has fueled the price increases starting in the second half of 2004. Life (or retirement) took on a new meaning for owners valuing their properties a year ago assuming a 10% or 11% cap rate, compared with an 8% to 9% cap rate today. Just this change in assumption can cause a value to jump by up to 25%. And after years of seeing property after property, many of which were less than five years old, sell for 50 cents on the dollar, the current market became too appetizing to skip. The average cap rate in 2004, however, remained above 10%, because there are still "average" and distressed facilities in the market and not all buyers have agreed that a new metric is warranted.
Many people predicted that cap rates would decline as seniors housing became a more accepted real estate class for traditional institutional investors, combined with the search for yield in today’s low interest rate environment. If multifamily housing cap rates are 5% to 6%, independent living should be 7% to 8% and assisted living 8% to 9%, or so the argument goes. While there is some merit to this argument, this cap rate compression is also occurring in a time of historically low interest rates when investors, flush with cash, are competing for yield. It is unclear what will happen when interest rates spike up in the future.
And the flow of capital into the assisted living market increased in 2004 as everyone realized the worst was behind us, occupancies were increasing, unit rental rates were rising and operators other than Sunrise Senior Living (NYSE: SRZ) began talking about development once again, although in hushed tones with a certain degree of apprehension. More lenders are bidding on deals and institutional equity providers, both domestic and foreign, have an increased interest in investing in the sector.
One thing that no one is talking about is the diminishing public equity market for assisted living companies. With the sale of Assisted Living Concepts now complete, there is currently just one pure assisted living company left that is publicly traded, Emeritus Assisted Living (AMEX: ESC), since Sunrise began to lose its "purity" over the past 18 months with a series of acquisitions. How this will impact the acquisition market in the next few years is unclear, but publicly traded companies in all industries tend to be the driving force in acquisitions, except in real estate, that is. But ah, is this a real estate business or an operating business? It really depends on whom you ask.
The independent living market did not fare as well as its two industry cousins, at least when it came to average prices last year. Mostly because of a lack of quality product, or should we say the preponderance of lower-end communities, the average price per unit declined substantially to just over $71,500, while the median sank to just over $63,000 per unit. One may call it the "Grand Court affect," since several of the very low-priced transactions were former Grand Court Lifestyles properties that are still be divested.
Slightly more than 50% of the independent living communities sold had an assisted living component, ranging from 18 units to 67 units, but that didn’t help the pricing. Only one-third of the communities sold were stabilized, while almost 30% had occupancy levels below 80%. The average cap rate for this asset class did, however, remain under 10% again. The results for 2004 in the IL sector should not be cause for any alarm, however, because as most buyers know, as soon as a high-end community comes on the market, the bidding will begin above $100,000 per unit, and unlike in 2004, we expect to see more of that in 2005.
As we come to the end of the first quarter of 2005, the acquisition market is as strong, if not stronger, as the last two quarters of 2004. Owners are rightfully concerned that they may be missing out on the peak in the market, but if interest rates remain low, the "peak" may be with us for a while. Our 10th edition of The Senior Care Acquisition Report, which is based on more than $1.3 billion of asset sales in 2004, will be available at the end of March.